UNIT 3

Disposable Income

v  Net Income

v  Paycheck

v  After-tax income

Marginal Propensity to Consume (MPC)

v  The fraction of any change in disposable income that is consumed.

v  MPC= Change in Consumption/Change in Disposable Income

v  MPC = ^ΔC/_ΔDI

Marginal Propensity to Save (MPS)

v  The fraction of any change in disposable income that is saved.

v  MPS= Change in Savings/Change in Disposable Income

v  MPS = ^ΔS/_ΔDI

Marginal Propensities

v  MPC + MPS = 1

v  .: MPC = 1 – MPS

v  .: MPS = 1 – MPC

Ø  Remember, people do two things with their disposable income, consume it or save it!

The Spending Multiplier Effect

v  An initial change in spending (C, I_G, G, X_N) causes a larger change in aggregate spending, or  Aggregate Demand (AD).

v  Multiplier = Change in AD/Change in Spending

v  Multiplier = ^{Δ AD}/_{Δ C, I, G, or X}

The Spending Multiplier Effect

• Why does this happen?

-Expenditures and income flow continuously which sets off a spending increase in the economy

Ø  Ex. If the government increases defense spending by $1 Billion, then defense contractors will hire and pay more workers, which will increase aggregate spending by more than the original $1 Billion.

-          The Spending Multiplier can be calculated from the MPC or the MPS.

-          Multiplier = ¹/_1-MPC   or  ¹/_MPS

-          Multipliers are (+) when there is an increase in spending and (–) when there is a decrease  

Calculating the Tax Multiplier

v  When the government taxes, the multiplier works in reverse

v  Why?

·         Because now money is leaving the circular flow

v  Tax Multiplier (note: it’s negative)

·         = ^-MPC/_1-MPC or ^-MPC/_MPS

v  If there is a tax-CUT, then the multiplier is +, because there is now more money in the circular flow

MPS, MPC, & Multipliers

Ø  Ex. Assume U.S. citizens spend 90¢ for every extra $1 they earn. Further assume that the real interest rate (r%) decreases, causing a $50 billion increase in gross private investment. Calculate the effect of a $50 billion increase in I_G on U.S. Aggregate Demand (AD).

v  Step 1: Calculate the MPC and MPS

-          MPC = ^ΔC/_ΔDI =  ^.9/₁ = .9

-          MPS = 1 – MPC = .10

v  Step 2: Determine which multiplier to use, and whether it’s + or -

-          The problem mentions an increase in Δ I_G .: use a (+) spending multiplier

v  Step 3: Calculate the Spending and/or Tax Multiplier

-          ¹/_MPS = ¹/_.10 = 10

v  Step 4: Calculate the Change in AD

-          (Δ C, I_G, G, or X_N) * Spending Multiplier

-          ($50 billion Δ I_G) * (10) = $500 billion ΔAD

MPS, MPC, & Multipliers

Ø  Ex. Assume Germany raises taxes on its citizens by $200 billion . Furthermore, assume that Germans save 25% of the change in their disposable income. Calculate the effect the $200 billion change in taxes on the German economy.

v  Step 1: Calculate the MPC and MPS

-          MPS = 25%(given in the problem) = .25

-          MPC = 1 – MPS = 1 - .25 = .75

v  Step 2: Determine which multiplier to use, and whether it’s + or -

-          The problem mentions an increase in T .: use (-) tax multiplier

v  Step 3: Calculate the Spending and/or Tax Multiplier

-          ^-MPC/_MPS = ^-.75/_.25 = -3

v  Step 4: Calculate the Change in AD

-          (Δ Tax) * Tax Multiplier

-          ($200 billion Δ T) * (-3) =  -$600 billion Δ in AD

Ø  Ex. Assume the Japanese spend ⁴/₅ of their disposable income. Furthermore, assume that the Japanese government increases its spending by $50 trillion and in order to maintain a balanced budget simultaneously increases taxes by $50 trillion. Calculate the effect the $50 trillion change in government spending and $50 trillion change in taxes on Japanese Aggregate Demand.

v  Step 1: Calculate the MPC and MPS

-          MPC = ⁴/₅ (given in the problem) = .80

-          MPS = 1 – MPC = 1 - .80 = .20

v  Step 2: Determine which multiplier to use, and whether it’s + or -

-          The problem mentions an increase in G and an increase in T .: combine a (+) spending with a (–) tax multiplier

v  Step 3: Calculate the Spending and Tax Multipliers

-          Spending Multiplier = ¹/_MPS = ¹/_.20 = 5

-          Tax Multiplier = ^-MPC/_MPS = ^-.80/_.20 = -4

v  Step 4: Calculate the Change in AD

-          [ Δ G * Spending Multiplier] + [ Δ T * Tax Multiplier]

-          [($50 trillion Δ G) * 5] + [($50 trillion Δ T) * -4]

-          [     $250 trillion         ] + [     - $200 trillion      ] = $50 trillion Δ AD

The Balanced Budget Multiplier

v  That last problem was a pain, wasn’t it?

v  Remember when Government Spending increases are matched with an equal size increase in taxes, that the change ends up being = to the change in Government spending

v  Why?

O      ¹/_MPS + ^-MPC/_MPS  = ^{1- MPC}/_MPS  = ^MPS/_MPS = 1

v  The balanced budget multiplier always  = 1